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Tuesday, March 8, 2011

You Know ECB Monetary Policy Is Tight When...

(1) Local communities such as this one in Spain resort to using old currency to stabilize spending.

(2) Ambrose Evans-Pritchard calls the ECB a flat-earth central bank for its handling of supply shocks and its attempt to kick Spain in the teeth.

(3) The ECB President says interest rates will be increased soon even though the core inflation rate declined in January and inflation expectations remain stable.

(4) An ECB Governing Council member says interest rates will rise as many as three times this year even though Eurozone nominal spending remains far below trend.

(5) Two ECB Governing Council officials say the ECB will actually tighten sooner than what is implied in (3) even though more credit downgrades are likely and credit spreads are increasing for the Eurozone periphery.

5 comments:

why is it valid to extrapolate a trend from 1996-2004? this seems to be entirely arbitrary. furthermore, you picked a period that includes 1) a tech boom (96-00), 2) the first half of a global credit boom (00-07), and 3) much of the gains from "convergence" (i.e. inappropriately low rates in c. 35% of the eurozone economy).

I chose this time because during this time aggregate nominal spending growth was relatively stable. I also chose this time because that is as far back as the OECD data goes for the Eurozone.

There are always going be various economic shocks. Monetary policy should aim to offset these shocks in a manner that keeps nominal spending growth stable. The figures indicates this happened 1995-2004 despite the developments you cite. Euro area monetary policy was doing a great job then. Thereafter, nominal spending grows too fast, then crashes, and yet has to recover to its pre-crisis trend path.

The Eurozone’s diversity of labor market practicies gives the impression that Spain was far harder hit than Germany. From the standpoint of monetary policy it is better to focus on output. (The following figures are rounded to the nearest percent.)

If one compares real GDP in 2009 versus trend growth from 1997-2007 one will find all the Eurozone-16 members were 6-10% below trend except Cyprus(5%), Finland(14%), Ireland (21%) Luxembourg(11%) and Malta (3%). Those nations account for little more than 3% of the eurozone’s output. The difference between Spain and Germany’s performance by this measure is trivial (10% versus 7%).

Do a similar comparison for the US and what you find is far greater dispersion in growth relative to trend. The following states were over 11% below trend: Arizona (16%), Florida (14%), Georgia (11%), Idaho (12%), Michigan (12%), and Nevada (18%). All told they account for roughly 15% of US GDP. The following states were less than 7% below trend: Alabama (7%), Alaska (-8%), Arkansas (4%), Colorado (6%), DC (3%), Hawaii (6%), Kansas (6%), Kentucky (5%), Louisiana (-2%), Maine (6%), Maryland (6%), Massachusetts (7%), Mississippi (3%), Montana (5%), Missouri (6%), Nebraska (5%), New Mexico (6%), North Dakota (-4%), Oklahoma (-8%), Pennsylvania (5%), South Dakota (0%), Vermont (6%), Virginia (7%), Washington (6%), West Virginia (-1%) and Wyoming (-12%). All told these states account for roughly 13% of US GDP.

So states accounting for 28% of US GDP were outside of the 7-11% below trend range versus countries accounting for 3% of Eurozone-16 GDP that were outside the 6-10% range. More substantial statistical analysis of the relative degree of dispersion involving weighting shows similar results.

Granted, there is greater labor mobility in the US, but this does raise the issue of which is really the better OCA, the US or the Eurozone. Despite the lack of awareness on this issue, there is actually a huge diversity in regional economic performance in the US.

It also underscores the fact that despite all of Germany’s bravado they are not vastly outperforming the rest of the Eurozone. Kurzarbeit obscures the fact that in Germany, real GDP, exports, manufacturing, productivity etc. are still lower now than they were nearly three years ago. The ECB’s tight money policy is not only bad for the periphery it is bad for the core, and the proof lies in the fact that Iberia and Greece are not doing all that much worse than Germany and France, and the gap is far less than that between some large US states.

It’s taken as gospel that the US is a better OCA than the Eurozone. But is this really true?

Not only does the U.S. have better labor mobility but we have a political union that allows fiscal transfers across the various regions. Thus, my fellow Texas and I are helping pay for the unemployment benefits up in Michigan. This makes the currency union more palatable for folks in Michigan.

With that said there is a literature that shows the diverging business cycles in the United States. I have an article in this area where I question whether the U.S. is truly an OCA. See here. Also see the discussion I had with Krugman and Avent last year on this issue.

David,My point is that nobody has yet tried to empirically measure the relative degree of dispersion in GDP growth in the US compared to the Eurozone this cycle. All sorts of assumptions have been made without anyone doing any real statistical analysis.